Central Banks Cannot Easily Maintain their Independence- Becker

Most richer nations nowadays, and many developing nations, have "independent" central banks, such as the European Central Bank and the Federal Reserve Bank. "Independence" cannot be precisely defined, but it is supposed to indicate that the central bank of a country has the freedom to make decisions which the government, represented by the Treasury in the United States, does not like. The purpose of independence is to allow monetary policy to be decided independently of fiscal policy, although obviously even independent banks and governments may respond in consistent ways to broad economic events, such as the present recession. The motivation for having an independent central bank is the many occasions in the past when subservient central banks accommodated the government's desire to spend more without raising additional taxes. Central banks accommodate fiscal authorities essentially by buying government securities that help finance government spending. In return for receiving government debt, a central bank would either directly print additional currency that governments can spend, or it would create reserves in commercial banks that lead to an expansion of bank deposits and monetary aggregates, such as M1. Either way, inflation would result from this monetization of the government debt, often severe inflation and even hyperinflation. Hostility to rapid inflation led to the political support behind giving central banks much greater independence from fiscal authorities. The history of the Federal Reserve's transition in and out of independence is illuminating (see Allan Meltzer's book, A History of the Federal Reserve, 2003). The Fed fully and enthusiastically compromised its independence from the Treasury during World War II. It bought large quantities of government debt to help the government finance the large wartime deficit. Inflation from the resulting big expansion of the money supply was suppressed through wage and price controls. This inflation became open after removal of these controls at the end of the war. For a half dozen years after that war was over, President Truman and the Treasury pressured then much more reluctant Fed officials into maintaining the Fed's subservience. Eventually, however, the Fed regained its independence in the famous Accord reached in March 1951. Nevertheless, the Vietnam War, the Great Society Program, and the reinstitution of wage and price controls by Richard Nixon in the early 1970s led to later erosions of the Fed's independence. Even during normal times, central banks, whatever their nominal independence, are under strong pressure to accommodate expansionist fiscal policy, especially as elections approach. During extraordinary times, whether in peacetime or during wars, this pressure usually becomes too powerful to resist. So the rather complete bending of the Fed to the Treasury's wishes during the present worldwide recession is not surprising. Still, that does not make it right, and I have some doubts about the Federal Reserve's recent behavior. One concern is the somewhat arbitrary choices the Fed made about which banks to bailout and which ones to close or merge into other banks. This added significantly to the enormous uncertainty already prevalent in financial markets. I am also worried about the Fed's support of the huge federal deficits generated by the sharp expansion in federal spending. I understand such actions are necessary to help governments fight wars, but why help finance so much spending during this recession, particularly spending that has dubious stimulating potential? One example is the almost $800 billion so-called stimulus package that will do little to stimulate the economy, but will greatly raise long term government spending in directions desired by the President and Congress (see the posts on January 11 of this year). Another example of dubious government spending that the Fed seems willing to help finance is the ill thought out Treasury plan for hedge funds and other financial institutions to buy toxic bank assets (see the criticism of this plan in my posts on March 29 and 31). The huge increase in bank reserves is a major consequence of the Fed's monetization of the government's large spending programs. Reserves went from about $8 billion in early Fall to around $800 billion, or a hundred fold increase in only 6 months. The recession rather than the wage and price controls imposed during prior periods is keeping inflation suppressed at present. Once the economy begins to recover, the inflationary risks will be enormous. In order to soak up these reserves, the Fed would have to sell large quantities of its government securities back to the private sector. These sales would put downward pressure on security prices- that is, upward pressure on interest rates- that will slow the economy's expansion at that time. For this reason, any government in power then, whether Democratic or Republican, will vigorously resist such Fed actions. Hence it is not obvious that the Fed will be able to conduct these sales sufficiently smoothly to prevent either a recession or a serious bout of inflation. These are not pressing concerns when a serious recession is the immediate problem, but they will become major challenges down the road.

Comments

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[Guojun]

I have read this blog for a while and would like to thank Prof. Becker and Posner for giving us this weekly insight from them. It seems that the recent track record of FRB is OK in that respect. For quite similar problem, former FRB Chairman Paul Volcker gave his answer, kept the interest rate high and squash the economy and maybe the presidency of Jimmy Carter. And Mr. Greenspan kept the interest rate and cost the presidency of Mr. Bush the senior.

Currently, maybe more worry falls on the other end of spectrum. It seems the premature hike of the interest rate prolonged or maybe worsened the 1930s great depression. And let us see what this time will be.

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[Jack]

More of a question than a comment:

While understanding that, typically, flooding the market with dollars tends to cause inflation, I wonder how that threat of inflation will manifest itself?

On the big purchase -- housing, say Fed actions increase interest rates: I'd predict new housing where pricing decreases are difficult if not impossible to achieve would continue to be slow.

Used housing would fall further in price as too few could afford to buy them were interest rates high. Both would mean capital is not in high demand tending to lower the rental price of capital.

Or? too many dollars chasing to few goods? We're at something south of 70% capacity with 10% unemployment with another 10% in make-work "jobs" that pay less than it costs to live the most basic existence. With........ a whole class of college and HS students ready to join the labor market in just a few weeks.

Many of today's products are virtually "extrusions" that are not too dependent on adding a lot of labor to increase output -- for example I suspect Dell or Apple could double output while hiring less than ten percent more people.

Are we expecting rapid price increases in such a market? Shortages? Of something?

Interestingly, I saw little concern with "inflation" as housing prices soared and the wages of the upper 20% and ONLY the upper 20% rose rapidly, or soared. Does THE "inflation" signal go off when lower income wages begin to rise?

Is the working bloke trying to purchase a home any worse off if housing falls 40% but interest rates rise a bit? or even a lot?

I really wonder when and how inflation is likely to take place. Good subject for another essay?

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Do you have any thoughts on the recent push to audit the Federal Reserve, as proposed on HR 1207?

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